‘The Snapback When It Comes Can Be Vicious’: Albert Edwards Thinks Credit ‘Isn’t Getting The Message’ (Yet)

Right, so in “It’s ‘Grotesque’! Of Buybacks And Leverage“, we highlighted a recent Bloomberg interview with SocGen’s Andrew Lapthorne who is just as concerned as ever about corporate leverage and is just as unconvinced as he was last year about the relative merits of employing financial engineering in the service of myopic, executive compensation-motivated buybacks.

While it’s always nice to see Andrew get interviewed, that Bloomberg piece kind of veers off into a discussion of the buyback angle at the expense of the leverage debate, which is certainly fine as the two issues are inextricably bound up with one another and also understandable because after all, who doesn’t want to talk about buybacks, right?

But the leverage point is important in and of itself for what it says about the extent to which the post-crisis monetary policy regime has discouraged balance sheet discipline by artificially suppressing borrowing costs as investors scramble down the quality ladder in search of yield.

It takes two to tango (i.e, if investors are willing to accept virtually nothing in the way of a spread above risk-free govies to loan money to corporates, then it’s unrealistic to think management won’t take advantage) but you can’t expect the investment community to “show discipline” in an environment where yield is an endangered species.

The relentless chase down the quality ladder catalyzed by central banks dumping $15 trillion-ish at the top of that same ladder ensures that everything gets priced to perfection on the way down, with the sole exception of companies that are on the verge of default. Recall this schematic from Citi:

This raises questions about what happens when the accommodation that creates that dynamic fades.

Ok, so although the Bloomberg piece doesn’t delve too deeply into that, Lapthorne’s colleague (and most famous bear on the planet outside of Yogi) Albert Edwards takes up the discussion in his latest note, mentioning Andrew’s interview before citing Michael Lewitt re: the the already infamous WeWork offering (funny take on that from my homie Thornton here).

Quoth Albert, quoth Michael Lewitt:

I don’t usually talk about companies but Michael’s insight into a company called WeWork deserves singling out. WeWork recently issued $700m of B rated junk bonds and in the prospectus included a wondrous new concept termed “community-based EBITDA” in its valuation metrics. For those with long memories this is surely be reminiscent of that series of spurious valuation metric such as price/eyeballs ratios that we saw at the peak of the 2000 tech bubble.

Michael writes, “This financial measure deserves its own place in the Bullshit Hall of Fame. The company defines “community-based EBITDA” in a painfully long footnote, but in plain English, it is earnings before interest, taxes, depreciation and amortization (i.e. conventionally defined EBITDA) but also before other normal operating expenses such as marketing, general and administrative expenses, development and design costs. This is, not to put too fine a point on it, a joke. It is a disgrace that underwriters allow this type of nonsense to be included in a prospectus.”

Well he’s a man who says what he thinks!

Yes, although really, Lewitt’s assessment is far tamer than Thornton’s (linked above) and isn’t even close to as egregious as some of our own criticisms of corporate shenanigans so good for Michael for showing restraint. We would have just said “fuck WeWork” and have been done with it.

Anyway, the overarching point is that spreads have become disconnected from fundamentals in credit and as Edwards notes, they’ve also become disconnected from equity vol.:

It’s worth recognizing that there are reasons why equity volatility is first in the firing line right now. Deutsche Bank’s Aleksandar Kocic has discussed this at length in a series of notes on the “hierarchy of vulnerability.” One important point he makes is that HY might actually be less vulnerable than IG. Recall this from late March:

While Implied/Realized ratios have been trading on top of each other, IG skew has been trading richer to its HY counterpart since the end of 2016, while IG vol continues to outperform HY vol pushing their ratio to new highs.

This seemingly counterintuitive result (IG seems to be more risky than HY) has a distinct “path-dependent” flavor. In the last several years, there has not been any significant defaults in the HY. With a long period of QE, most of the issues associated with HY have been perceived as the problem of the past. As robustness of the HY had been accepted, IG, at the same time, has become associated with macro-systemic risk. Gradually, HY vol became the funding leg for multitude of cross-asset trades, while IG compression towards all time low made it vulnerable in a broader context. As a consequence, the spread between IG and HY vol continued to widen.

Ok, so that’s a bit of an esoteric discussion and I don’t want to get too far into the weeds with it in this piece (those interested can read the two linked posts above that cite Kocic).

Rather, getting back to Edwards, there are justifiable concerns about what the fallout will ultimately be when the incessant spread compression associated with the QE era reverses course against a backdrop of, to quote Lapthorne again, “grotesque” leverage.

Here’s Albert:

The dollar’s surge is occupying investor attentions. After more than a year of ignoring widening interest rate differentials that favoured the dollar, the market has reengaged. A similar possibility might lie in wait for corporate bond spreads that have so far resisted the rise in equity volatility. And another straw in the wind may be the performance of a newly issued junk bond of a company called WeWork who have invented an entirely new, nonsense valuation metric – “community-based EBITDA”!

My colleague Andrew Lapthorne was recently interviewed by Bloomberg. Focusing on one of our key themes he said, “Higher interest rates are already doing damage, people just haven’t noticed. Leverage in the US is grotesque for this stage of the cycle. At the moment you’ve got peak leverage at peak prices. It’s not like you have to dig deep to find a problem.”

The corporate bond market doesn’t seem to have got the message with spreads, so far, studiously ignoring rising equity vol. But as we have just seen with the re-coupling of the dollar with bond spreads, the snapback when it comes can be vicious.

And while I wouldn’t call this “vicious” quite yet, it’s worth noting that credit persists in leaking wider. In fact, IG OAS hit a new 2018 wide late this week at levels we haven’t seen in eight months.